The central bank in the UK pledges to keep interest rates low for years to come but that still might not be enough to achieve the desired result.
The current slump in the global economy is proving frustrating for economists who had come to think of themselves as bastions of sound economic management. Tried and tested policy tools such as changing the level of interest rates have only had a limited effect, as have new ideas such as quantitative easing (for more, see Why is the economy still in a rut?). Mark Carney set out to begin his stint as the new governor of the central bank in the UK with a bold fresh approach to monetary policy but his timid initial parley seems to be a rehash of existing measures. The new stance taken by the Bank of England aims at making low interest rates more attractive but it does not seem as if anyone is interested.
The not-so-new policy concept announced by the British central bank was that of forward guidance which entails providing greater clarity in the future direction of interest rates. This is expected to improve the intended effects of interest rates which are set by the central bank depending on the state of the economy. The Bank of England has set its base interest rate (which determines most other interest rates in the economy) at 0.5% since May 2009 but what is different with forward guidance is that Carney has stated that the base interest rate will stay at this level until the unemployment rate falls from 7.8% to 7.0% which is not expected to happen until the middle of 2016.
In other words, the Bank of England is promising three more years of record low interest rates. But this pledge comes with a big caveat – the central bank may raise interest rates if inflation looks set to stay above 2.5% over the medium term (economists are a bit neurotic about inflation – for reasons why, see Time to rethink Inflation?). So Carney has tried to provide as much clarity as possible on the future of interest rates while leaving himself leeway to change interest rates earlier if necessary. The Bank of England already gave some guidance on interest rates but linking the interest rates with unemployment makes this more explicit. A similar policy framework has been tried elsewhere – most notably in the United States where the Federal Reserve has also committed to low interest rates until the job market improves. But it is as yet unclear whether the forward guidance has had any notable effects.
The theory behind low interest rates and forward guidance is as follows – low interest rates when the economy is on a weak path are intended to entice firms and consumers into borrowing more and spend this extra cash to help make up for any shortfall in demand. But this has not worked out so far as lending by British banks has been falling since the global financial crisis. Guidance whereby low interest rates are pledged for an extended period of time is meant to fix the aversion against taking on debt by easing concerns that any borrowing now will be penalized with higher interest rates once the economy picks up – thus adding to any impetus to take out a loan. But Your Neighbourhood Economist does not hold much hope for forward guidance to add much punch.
For forward guidance to work, economists are relying on a piece of theory known as rational expectations. This assumption is that companies and consumers respond not only to current prices (including interest rates) in an economy but also expectations of these prices in the future. Since low interest rates have not had the intended effect, economists have seemingly come to the conclusion that it is because of worries that the low interest rates will not last. And so the hope is that by alleviating these concerns with forward guidance this will spark the borrowing that is meant to spur the economy into life.
But to Your Neighbourhood Economist, it seems like trying to tempt shark attack victims back into the water by convincing them that the water is shallow. This is because lots of companies went bust in the aftermath of the global financial crisis due to having borrowed too much. Consumers too are still overburdened with excessive debt no amount of low interest rates ever seems destined to fix at this point in time. The notion of rational expectations does not match up with what could be deemed as irrational fears of debt – hopes for borrowing our way back to economic growth seem too scary for most.